Bond Funds or Individual Bonds?
As with most choices in investing, the question of how to allocate the fixed income portion of a portfolio does not have to be exclusively one or the other. However, there are distinct advantages (as well as misconceptions) to both approaches that should be considered.
Regarding misconceptions, we have lost count of the number of times someone has brought up the idea that by owning only individual bonds that they hold to maturity, the only way they can lose money is if the bonds default, which is not true for a bond mutual or exchange-traded fund that is subject to the vagaries of interest rate increases (i.e., Treasury bond price decreases) and potential downgrades of corporate and municipal bonds (yes, we know, Treasury bonds can be downgraded too, as they were in 2011 by Standard & Poors). As with bond funds, individual bonds (with a few exceptions) are marked to market on a daily basis. While an investor may say that he simply does not care about intermediate prices before his bonds mature, there simply is no compelling reason to adopt that attitude for bonds owned individually as opposed to bonds owned via a fund.
The primary advantages of a low-cost bond fund are diversification, liquidity, and low trading costs due to economies of scale. Diversification is essential for mitigating credit risk. Regarding liquidity, we often hear the objection that liquidity is irrelevant because the individual bonds will be held to maturity, but in the event of a bear market in equities, you certainly want to have the option of selling a portion of a bond fund to buy stocks. Trading costs of individual corporate and muni bonds can be prohibitive, and individual retail investors operate at a significant informational disadvantage. Often, there is no explicit commission but rather a “markup” that is invisible to the bond buyer. According to Morningstar, “Markups are usually from about 1% - 5% of the bond’s original value.” Naturally, lower trade amounts carry higher markup percentages. Needless to say, if you are in the unfortunate position of selling a bond before maturity, you will suffer a markdown of a similar amount.
One of the advantages of individual bonds is the ability to tailor future cash flows to a specific need. For example, a bond ladder may be used to create a stream of income in retirement for a fixed term. Please note that if the cash flows (i.e., coupon payments and proceeds of maturing bonds) are only used to buy new bonds, then functionally speaking, the investor would simply have a personalized version of a passive bond fund. While he may save money by avoiding a fund expense ratio, it is likely that he would lose at least as much on trading costs and cash drag, not to mention the additional risk resulting from a low level of diversification. All of this is aside from the amount of time that would be needed to research and manage the bonds. Yes, these activities could be outsourced, and if he is paying an advisor a 1% annual fee, then he is looking not so different from a high-cost, actively-managed bond fund. another advantage of individual bonds is the ability to specifically target a particular credit and/or maturity level. For example, it may be difficult to find a low-cost fund that only holds AAA-rated muni bonds of maturity ten years or under. Finally, for investors subject to a high level of state income taxes, taxes can be reduced by focusing on muni bonds of that state. Note that for larger high-tax states like California and New York, there are still some good fund options from companies like Vanguard and Dimensional Fund Advisors (DFA).
Finally, a third option for consideration is a Unit Investment Trust (UIT), which can be thought of as a bond fund that is frozen in that it will not accept new funds nor place trades. It will only pay out the proceeds of coupons and maturing bonds until the fund is depleted. It offers the advantages of diversification and the avoidance of trading and management costs. On a cautionary note, UITs can be laden with fees such as sales charges (both initial and deferred), a creation/development fee, and an annual operating charge. Another downside of a UIT is its lack of liquidity.
At Clarity Capital Advisors, we strive to help investors address complex questions by avoiding a one-size-fits-all approach. Let us help you with your questions about planning and investing. Call us at 800-345-4635 or e-mail us at firstname.lastname@example.org.